1. Supply chain finance: The Indian approach is outdated

Supply chain finance: The Indian approach is outdated

A rapid increase in options for small firms, and intermediaries willing to take on risk will put pressure on the large firms that abuse the smaller suppliers.

By: | Published: April 19, 2017 5:42 AM
To achieve rapid inclusive growth, including higher employment levels, India needs to create more firms, and the better of these newer, smaller firms need to be able to grow rapidly. (PTI)

Policymaking in India is subject to multiple demands, and often lacks focus as a result. Implementation is often hampered by inertia and lack of expertise. Both these conditions contribute to India’s economic performance being short of what it can and needs to be. In recent columns, I have been highlighting continued policy failures in higher education and how digital technology can help. Supply-chain finance is another very important illustration of these issues.

To achieve rapid inclusive growth, including higher employment levels, India needs to create more firms, and the better of these newer, smaller firms need to be able to grow rapidly without unnecessary constraints. A crucial source of constraints to growth for these firms in India is finance, especially short-term finance. Smaller firms in India are often part of the supply-chain of larger firms, and they get squeezed mercilessly by their large firm customers, with payment delayed for many days. Demonetisation only compounded the woes of smaller firms, and the matter needs urgent policy attention.

Almost a decade ago, the 100 Small Steps report on financial sector reform, produced by a committee led by Raghuram Rajan, floated the idea of setting up an electronic exchange that would allow smaller firms to sell their receivables at a discount, freeing up liquidity for their day-to-day operations. Larger firms, by contrast, can already use supply-chain financing options developed by banks or other financial sector firms. There is significant scope for further development of this financing for large firms, but smaller firms have the greatest problem, and are the most under-served.

The government tried to legislate the problem of delayed payments in the MSME Development Act by requiring payments within 45 days, but as with many other examples of legislation, enforcement is difficult if not impossible. The exchange idea finally got traction when Rajan became Governor of RBI, and in 2014, a concept paper was released, followed by guidelines, and, the next year, the selection of three applicants to set up and run a new Trade Receivables Discounting System (TReDS), the name of the electronic exchange.

TReDS is finally near to implementation, and it will be important for it to be ramped up quickly. The government has mooted making its use mandatory for corporates and public sector undertakings, to get it started. On the other hand, only smaller firms will be able to participate as sellers. Banks and other financial sector companies can act as financiers. The participation of these intermediaries will be crucial. The gain in efficiency will come precisely from the transfer of claims on larger buyers from small, liquidity-constrained firms to intermediaries with greater financial resources and ability to enforce contracts.

RBI gave approval to three entities to create platforms under the TReDS rubric, and only one of them (Receivables Exchange of India Limited) has formally launched, but there is no evidence that its use has taken off. There are some concerns about the costs of registration of transactions for smaller firms, “know your customer” regulations, and the constraints on those who can participate as financiers. There are always going to be issues of risk management and fraud prevention in financial market settings, but RBI and the government may need to think seriously about making the new platform usable and effective for the clients it is meant to serve, namely smaller firms.

Meanwhile, “fintech” firms in developed countries, where supply-chain financing is already much more efficient than in India, are finding ways to harness information technology to intermediate between small suppliers and their larger business customers. These companies are also using electronic platforms, but without the mandated structures of the Indian effort. This raises an important question, namely, whether the current Indian approach is already outdated: the essence of information technology is the possibility of flexible, decentralised solutions to market imperfections.

It may be that Indian regulators will be reluctant to allow further innovation in supply-chain financing until TReDS is well-established, but the success of purely private initiatives in developed countries strongly suggests that greater flexibility in TReDS should be considered with urgency. It has to be noted that the source of risk in this market is large companies, which delay or even default on payments to smaller suppliers. Whatever electronic approach to supply-chain financing is adopted in India, small suppliers that get paid earlier are not any potential problem. And if financial intermediaries are willing to take on the risk of delayed or defaulted payments from large firms, they should be allowed to do so after meeting qualification requirements.

The only beneficiaries of the current system are larger Indian firms that abuse their smaller suppliers, and a rapid increase in options for small firms in the supply-chain and intermediaries willing to take on risk will only put pressure on large firms. Ultimately, as the experience of developed countries has shown, even these large firms will benefit in the longer run from changing their practices to make life easier for their suppliers. More liberal regulation and more rapid innovation seem like a no-brainer in this nascent digital market.

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